Improving ETFs Following the Flash Crash

Assigning blame for last Thursday's "Flash Crash" will take considerable resources and many months, and the conclusion is unlikely to single out a primary culprit. A probable conclusion is that the momentary lapse in the market's collective reason is a symptom of a systematic gap to accommodate the increasingly complex nature of securities markets.

Many predicted years ago that relying almost exclusively on computers, rather than humans in a trading pit, would lead to eventual market meltdowns. The human element of sound reasoning and seat-of-the-pants judgment would be necessary to facilitate a functioning market in periods of great duress. During these critical moments, it appears the critics were right. Simply transitioning from a computer-based system to the "slowdown" mode, in which humans are more involved, resulted in a momentary but monumental collapse on May 6.

But before we assess the shortcomings of the current system, let's focus on the few good points.

First, while the market crash seemingly lasted hours for those of us who were following the event moment by moment, a great majority of securities were trading at reasonable prices within 20 minutes of the onset. There was an eventual return to orderly conduct, which means those of us who did not trade during the period were not immediately impacted. Furthermore, two major exchanges acknowledged that several trades were executed so far beyond the realm of reason that they would take the unprecedented step of reversing some trades.

I applaud the exchanges for doing something they had never openly considered on such a large scale before, and I appreciate the timeframe under which they acted. It is often said that, when time is of the essence, a violently executed plan is better than a well-laid plan conducted at a later date.

To be sure, time was of the essence, because a security purchased one hour ago in a portfolio could easily be sold right now. What if I had been fortunate enough to purchase an ETF that had fallen 99% during the crisis (I was not that lucky, and I still have not found an individual investor who managed to get an order executed in the 15 minutes following 2:42 p.m. EST on May 6), and decided to sell my fund later that day? If my purchase decision had been nullified, I would now be sitting on a short position on that ETF, and to no fault of my own. Any action taken by the bourses needed to be fast, and for that, they deserve credit. But that is where the kudos end.

When Something's Not Right, It's Wrong
The conundrum of the trade nullification order is that there are two right answers. On one hand, there is a solid argument for canceling no trades whatsoever. A trade conducted on an exchange is a binding contract between two parties at an agreed-upon price--no matter what that price ends up being. If you entered a market order, as opposed to a limit order, to sell a security during the turmoil, you made a decision to part with your security at whatever price the most willing buyer would pay. Granted, precedent had been set that a willing buyer almost always appears near the last quoted price, but there was never a guarantee. Bid and ask prices have long been the price discovery mechanism for securities traded throughout the day on an exchange, and the vast majority of the time, they are effective.

The other right answer is to determine which securities exchanged hands at corrupted prices and reverse all of those trades. If the system broke down for certain securities, all the trades should be nullified regardless of price.

However, the exchanges instead drew a line in the sand, stating that any trades executed between 2:40 p.m. and 3:00 p.m. that were performed more than 60% away from the last print at 2:40 p.m. would be canceled.

The wrong answer is a compromise when there is no regard to relative value. The obvious question is: Why 60%? This arbitrary figure might solve the most egregious differentials between price and perceived value, but taking a 50% loss on a diversified basket of stocks, which most ETFs are, in a single day is well beyond any historical precedent. The simple answer is that the exchanges are not exhibiting any reasonable relationship between price and value. Their interpretation is "Everything is worth what its purchaser will pay for it"--unless it's 60% lower than it was a few minutes ago. That might be harsh but necessary medicine to take if you are talking about individual stocks, but not a fund.

 

Another concern I have with the current trade nullification solution is that the exchanges get to claim that they corrected the situation when, in fact, many victims remain. The market as a whole may not feel any pain four trading days later, since nearly $1 trillion in paper wealth went poof and then unpoof. But the problem remains, when the value of the market reappeared, much of it appeared in new hands. The deck of assets was reshuffled.

With a stock, it would not be unreasonable to assume that its value could drop 50%--or even 99%--in a moment's notice due to company-specific information that was just announced. It also would not be unreasonable for that same stock to rebound within moments if the information proved to be false. But it is unreasonable to assume that a basket of hundreds of stocks would suddenly lose 30% to 50% of its value in an instant when the underlying securities in that basket in aggregate are not down half that much. It appears that the system of reporting index values every 15 seconds for each ETF functioned well during market duress, so would it not be more prudent to calculate "fair" prices for ETFs during that timeframe based on a set deviation away from the indicative net asset value? And, if that is true, compensation is due to several sellers who lost 20% to 59% of the value of their trade in those waning moments.

This question resonates with ETF holders in particular because the majority of all securities impacted were not stocks at all--they were funds. ETFs made up over 70% of the securities with canceled trades, and closed-end funds made up another 5%. The more we investigate the issue, it does not seem to be a problem caused by ETFs; ETF investors were the victims of an inadequate market system.

It is potentially too late to solve the problem this time around, but these are all considerations that need to be addressed for future anomalies. Given the fragility and complex nature of our automated systems, these complications are bound to happen again. And again. The exchanges and regulatory agencies need to recognize the differing attributes of exchange-traded funds when compared to individual securities, even if they change hands on the same bourse. After all, ETFs often make up the majority of trades today, so the exchanges have a vested interest in their viability. If the collective market loses confidence in ETFs, the exchanges will suffer a great deal.

ETFs are no longer the product of a cottage industry that can accept such inefficiencies, even if the majority of their investors were not directly impacted and the blame lies with a third party. This is a trillion dollar industry whose promising future is predicated on the influence it can impart on its market participants in an immediate and definitive fashion. Much can be learned from the situation, wrongs can be made right, and the industry can emerge stronger than before. We expect the product providers to take a leadership stance in promoting a more efficient marketplace, and we believe they should start with the Authorized Participants and market makers that so often make a profit providing liquidity during periods of normalcy. If those parties are going to be paralyzed in the face of adversity, then the product suppliers will have to qualify every statement they make regarding the liquidity and price efficiency of ETFs.

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